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Corporate finance

Using debt to drive growth

May 13, 2024

People normally think of debt as a bad thing. It's true that poorly managed debt can become problematic and hold back a company's growth. But taking on debt can also be an effective way to finance a business's start-up or expansion.

For small and mid-size businesses, debt is an integral part of sound financial management—provided that it's used properly. In order for debt to pay off and drive growth, it needs to be part of a thoughtfully planned and realistic business vision. It also needs to be temporary and cost less than the profits it generates. That is known as "good debt." 

Short- or long-term financing? It depends.

Long-term financing should only be used for long-term goals. Getting a loan can give your business the means to diversify its activities or boost its productivity. For example, the funds can go toward developing new products or creating a transactional website. Initiatives like this can bolster earnings and add value to your business. Meanwhile, short-term needs, like purchasing goods, paying suppliers or other everyday operating expenses, can be covered with a credit card or line of credit.

According to Stéphane Royer, who manages Business Special Loans and Risk Management at Desjardins, it's normal for businesses to carry debt. In fact, it can even be desirable. However, businesses need to manage debt effectively and make sure they use it for the right reasons.

Is it normal for businesses to take on debt?

Yes, if the debt helps the business position itself to grow, seize opportunities, enter new markets or make other similar moves. It's common for companies to need financing to buy equipment, automate operations, expand their facilities or acquire other businesses. But loans need to be reasonable and well-thought-out. Borrowed amounts should support a clear business vision and concrete objectives. Ultimately, the goal is to reduce your debt so you can reach a more comfortable level of financial maturity.

To summarize, "good debt" is productive debt. It helps businesses make essential investments to help them advance or grow. In contrast, "bad debt" is when a business borrows money to cover a financial shortfall or buy things that aren't essential.

When should you be concerned about debt?

When a business takes on debt, it runs the risk of not being able to pay back its loans, invest in growth or weather the unexpected. Debt can become concerning, or even overwhelming, when you don't have any remaining financial leeway.

For example, if your business applies for financing but gets turned down, it can be tempting to simply try your luck elsewhere. After all, another lender may be willing to provide credit, but with less favourable terms. But ignoring warning signs is like putting your head in the sand. A wiser approach would be to assess your cash inflows and outflows before things get to that point.

Make sure you always have a financial cushion

Having sufficient cash assets, also known as working capital, is vital to your business's health. Managing your cash effectively will ensure that you've got enough reserves for unplanned expenses. These funds are important for covering operational needs while you wait to receive payments. A credit card or line of credit can help your business meet its short-term needs.

Before you consider getting a loan, make sure your business's assets outweigh its liabilities. Having a healthy balance sheet is key for sharing the risk between your financial institution and your business. According to Lucien St-Amand from Desjardins's Banking Services, how much a business needs depends on its industry and future plans, but a good starting point is generally to have somewhere between $1.00 to $1.20 in assets (accounts receivable, inventory, cash) for every dollar of liabilities (accounts payable, debts).

Adapting in good times and bad

High inflation can lead to additional challenges for a lot of businesses, as they deal with slower sales and new consumer habits. Global events can make it extra hard to manage a company's finances, make business decisions or recruit workers. Sometimes temporary measures are needed to prevent unpleasant surprises over the long term. One possibility could be to scale back your business plans as a means of cutting costs—and you might just find that it leads to new opportunities. For example, it may be a good idea to stop offering certain products or services so that your business can focus on its most profitable activities. The same could be true for your distribution channels; critically reviewing their efficiency and profitability could help your company save money and maybe even spur your online business development. 

Getting valuable support

When you need to make financial decisions, be sure to get input from key stakeholders like your director of finance, senior account manager and other trusted individuals. It's helpful to hear from people with a wide range of backgrounds, experience and expertise. They'll be able to offer you different perspectives and help you ask the right questions about your plans and business decisions.

In short, be proactive and ask for advice—before your business is in trouble. A professional will sit down with you to review the legal considerations and find the best solutions for your business. Getting good support is key to sound business management. There are many different ways to address problems. You'll inevitably have some decisions to make, but with an action plan in hand and the right people at your side, you'll have a clear understanding of the situation and what you need to do to be successful.